By Ian Bates, CFA
Despite bearish sentiment, factors including a shrinking market, fund flows, higher yields and a stronger economic outlook have supported the sector this year.
Entering 2023, the tone among many market strategists concerning European high yield market was exceedingly pessimistic, with their year-ahead outlooks warning of the growing weight of fundamental risks.
Yet, by the end of the first half of the year, total returns of approximately 4.5% in the asset class had erased over a third of last year’s losses, the worst in 15 years.
From its nadir in September 2022, the market has bounced back by over 8% – supported by improved stability in the rates market, but also by a reduction in the credit risk premium, with spreads rallying by over 50 basis points in six months.1
Why was the market consensus so wrong?
First, the year began with excessively bearish sentiment and positioning as investors feared an energy crisis in Europe, a painful recession and consequent acceleration in inflation.
Also of concern were geopolitical risks such as the Ukraine war, ongoing post COVID supply-chain disruption and, most importantly, the real-world implications of the sharpest monetary contraction in decades.
In retrospect, some of these concerns proved unfounded. Not only was there no recession or energy crisis, but energy costs actually fell materially, putting a positive tailwind behind earnings. Although still uncomfortably high, inflation has begun to moderate in many areas, and supply chains have returned to normal, aided by the Chinese reopening.
Second, investors underestimated the strength of technical support for high yield.
Funds flows have turned positive, with investors attracted by a yield-to-worst that has risen from below 3% in 2021 to nearly 8% today. Although defaults may increase this year, their current 12-month trailing rate of about 1% is so low that we would likely need to see a very significant increase for total returns to go negative.2
The European high yield market has grown threefold since 2010, with its notional value rising from about €120 billion to over €400 billion. However, its growth is likely to slow due to a fading leveraged buyout boom and limited current primary issuance (which consists mostly of refinancings).
In fact, net of interest receipts, opportunistic buybacks, calls and redemptions, the market is actually shrinking in size.
With European high yield spreads currently at the tight end of their recent range, we believe they have room to widen into year-end given signs of margin pressure, although this is likely to be tempered by a continuation of strong technicals. Overall, we believe the asset class looks to be on track to add to recent gains over the balance of the year.
1 ICE BofA European Currency Non-Financial High Yield 3% Constrained Index2 JP Morgan Credit Research Publication
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